Thursday, June 30, 2016

The Process of Capital Formation

Capital formation is a process that is vital to help facilitate economic growth. With an upward trend in economic growth, new jobs can be created, technology, innovation, and etc. With regards to the concept of Capital, it comprises many items, viz: Money, equipment, Real Estate, machinery, etc etc. With regards to this article, the focus of Capital Formation will be simply cash and its equivalents.


How is Capital Formed?

It all starts with human action. Humans seek to improve their circumstances via voluntary exchange. Voluntary exchange takes place, as the actors in the marketplace continue to produce and trade. In this process, humans will seek to place some "capital" aside. They may place it in a mattress, coffee can, a hole in the backyard, a pillow, or with a financial intermediary. Some examples of a financial intermediary are as follows: A bank, credit union, investment brokerage, and insurance company. Once the actors begin the process of production, some of the "savings" goes into the bank. This is the start of the process on how capital is formed.

The Role of the Financial Intermediary

As actors in the market begin to produce and engage in Voluntary exchange, the money is stored in a financial intermediary. Financial intermediaries, in turn, seek to "grow" their capital base. This base comes from the depositors. The financial intermediary seeks to market loans to others in the market place. These loans, limited to the scope of our analysis, are used to help business owners acquire capital equipment, fund labor, purchase real estate, and other economic inputs. 

The Natural Rate of Interest

The concept of the natural rate of interest is derived from the Law Of Marginal Utility. In short, it is the ratio between present goods and future goods.  With that ratio, and other factors(risk, etc), the financial intermediary charges interest for borrowers.  Another point to add: it is indicative of the temporal preference of things on the individual's utility ranking. Each of our actions precede the next action. Those actions we select first are preferred over the latter actions. If those actions involve some voluntary exchange, with prices used in the exchange, the interest rate can be calculated...somewhat. In our analysis, the actor simply defers his capital for present consumption and places it into a financial intermediary. For those who use the bank to store capital, the bank provides an interest rate on those monies.  This rate of interest acts as a signal to the actors in the marketplace, as it is tantamount to a price. The rate of interest will fluctuate as the actors are constantly moving towards an over all equilibrium. In an un hampered market, all the actors in this scenario, seek to balance present needs vs future needs. 


Conclusion

With the process of capital formation, it begins with productivity. The actors involved in the labor market place aside some of their earnings, as they prefer to use that portion for future consumption. In turn, financial intermediaries loan out monies from this capital base to business owners, individuals and the like to help them acquire assets. 

Sunday, May 22, 2016

Prices: How are they derived?

Bread $2.00/loaf. We see this at our local grocery store. This price sends a signal to us. If it does, what signal is it sending? It is obvious that the $2.00/ loaf is the signal, prima facie. Yet, there is more to this process.

Prices are signals to both parties in the free trade process. However, how are they derived?

Barter
In the past, free traders used barter to exchange goods. The "prices" of those goods were expressed in the other good that was needed by the seller. For example: If a seller of a cow needed two hens, the price would be two hens. 

Money

As barter was replaced with money, the unit of money represented the price.(e.g 1 hen= 2 gold coins) This made the process more efficient for both sellers and buyers on the transaction.  With the case of money, prices are stated in terms of money, as in this example, the number gold coins.  With money, we can carry it forward with currency, as the prices would be expressed in terms of the respective currency type. (e.g. USD, Euro, Pound, etc)

Price and Subjective Value

Money is a means to do multiple things. It helps maintain a level of recordkeeping or accounting of transactions, as we previously discussed since prices are presented in terms of money.  Money also is used to "store value". This concept of "storing value" is a curious one, since value is subjective. While this is true, the money used may not and does not measure all the value expressed in the transaction. However, we can see what things people  value over another based on the law of marginal utility. Hence, prices play an active role in helping the economic actor to evaluate his utility preferences. 

Prices, therefore, are spawned out of a need to attempt to quantify subjective value for the economic actor. As the actor is moving to improve his situation, he goes to acquire more "stuff". In this pursuit, he will make choices on the acquisition of "stuff" based on his preference ranking. Note: this preference ranking is dynamic, thus it is constantly changing.  

Conclusion

Prices act as a valuable tool in the free market process. They provide vital information to the economic actors. The primary purpose for prices is the attempt to project value in terms of the money displayed. While prices can not quantify the true value for the economic actors, it does provide a way for the actor the ability to prioritize his wants and needs accordingly. 

Thursday, April 7, 2016

Money Supply and the Velocity of Money

Money Supply and the Velocity of Money: The Mainstream View of Money Velocity is flawed. It compares the movement of money like movement of an object in the science of physics. All of it is based on the notion of the equation of exchange. Analysis of that equation and the notion of "The Velocity of money" will be covered at another time.

Sunday, March 13, 2016

More Thoughts on Interest Rate

The Interest Rate: The mystery. The intrigue. Most individuals concern themselves about this when they are purchasing a home loan, acquiring credit cards, or purchasing a new vehicle. However, this notion is much broader than obtaining more debt. It is much broader, yes, much deeper than imagined, as is not well understood, even by philosophers, economists and finance scholars. The natural rate of interest, or ordinary interest, is inherent in every thing we do as actors in a "free market" economy.

What is the Natural Rate of Interest?

Classical Economic Model

There are two divergent models of analyzing the notion of natural rate of interest. The first model is derived from the Classical Economic school of thought.  This model is based on the popular Economic frame work of supply and demand. Simply put: The interplay of the supply and demand of money, produces a particular interest rate.(Ceteris paribus)  For example, if demand is held constant, and the central bank increases the monetary base, the interest rate would fall. Conversely, if the Central bank decided to reduce the money supply, with demand remaining constant, the interest rate would rise (Ceteris paribus) If this is analyzed from the demand side, if demand rises for the currency, and the currency bases remains the same, the interest rate rises.(Ceteris paribus). If the demand for the currency falls, and the currency base remains the same, the interest rate will fall.(Ceteris paribus) This Classical model of analyzing the interest rate views things at a macroeconomic level.

Marginalist Economic Model

This model was specifically pushed forward by Marginalist Economist, Eugen Bohm Bawerk. As per Bohm-Bawerk et al, the notion of the natural rate of interest speaks to the time preference of consumption from the individual actor in the marketplace. To Wit: The time preference of from the individual's consumption between today's goods, as compared to future goods. Notice that this definition has little to do with the bank's rate of interest, although the bank's rate is a singular actor's rate of time preference, as that actor would be the bank. This ratio, nets the prices between the two respective time periods. Of course, this activity is not a static, so the interest rate is constantly shifting, modulating and changing, as the actor's preferences change.

Interplay of Interest Rates to Meet Equilibrium

Going back to the Financial Intermediaries, e.g Banks, Credit Unions, Financial Institutions, Insurance companies, and etc.) need to manage cash and their monetary equivalents, these institutions' role in the market economy is vital. They are responsible for allocating scarce resources, to wit, providing cash capital to entrepreneurs. Many people mistakenly assume the bank's interest rate is the same as the natural rate of interest, as this is demonstratively false.

Let us suppose that the bank's interest rate is 5%, and the natural rate of interest, in the marketplace, was 8%. The bank would loan out, or invest, or place money in capital goods that would yield a 8% return. This process would continue until the bank's interest rate matched the return on those capital goods. Why does this happen? As the bank continues to invest or loan out money into those capital goods, the demand for those monies and goods rise. As the money demand rises, due to the need to invest in capital goods, the bank's price on money, the interest rate, rises. Once the bank's interest rate, and the return on investment in capital goods equals the same rate, it makes no sense for the bank to move money into those capital goods.

What happens if the natural rate is below the bank's interest rate? If the bank interest rate is 5%, and the natural interest rate is 3%, the bank will not seek to loan or invest into capital goods at that lower rate. What may occur is the following: Banks may continue to hold the cash, at 5%, until the demand for long term capital projects rise above 5%. In this case, as in the prior case, the opportunity cost of the bank's money must be considered.

Banks are seeking to profit from the arbitrage: In the former case, the Bank seeks to make a profit from the spread of 8%, the natural rate, and the 5%, the bank rate. As for in the latter case, the bank seeks to take a more conservative position and hold onto its cash. In both cases, on the long run, all actions will seek to meet equilibrium.

Based on these two examples, the bank's interest rate will not equal the natural rate of interest. This is true since there would be no profit seeking opportunities. The bank's funds would sit idle, no cash capital would move other sorts of capital markets. This sort of analysis demonstrates that these two interest rates are not the same.

An Example of the Use of Interest Rates in the "Real World"

With a business that is capital intensive, management of this capital equipment is vital for the success. When a business owner is seeking more cash capital to acquire a piece of capital equipment, he should be factoring how this equipment can benefit his operation, on the margin. He will look at how the marginal cost impacts the marginal benefit. If the firm has extra cash, or investment capital, it will seek to obtain a return on investment on that capital. So, if the owner of the firm is purchasing a piece of manufacturing equipment, and will yield a return on investment higher than the natural rate of interest, and the current "bank interest rate", the business owner will invest in that manufacturing equipment. The owner, like all humans, is engaged in a profit seeking enterprise. And, it is that profit that is his return on investment.


Conclusion

As with all things, in the capital markets, actors are constantly pushing towards equilibrium. All actors are seeking a state of peace, or in economic terms, equilibrium. The constant ebb and flow of the play between the natural rate of interest, and the interest rate placed by financial intermediaries demonstrates this. The natural rate of interest simply is an expression of human action, as the individual's preferences span throughout the space/time continuum. 





Friday, February 26, 2016

Fired? Dont Leave Any Money Behind

You lost your job. Life can send us curve balls at times. However, we can still recover. During the recovery process, while you are looking for another job, do not forget about your money. Many think that leaving the money in the prior job 401k(or similar plan) after being fired, is the prudent thing to do. Nothing can be further from the truth. Who is better at managing your hard earned cash? You? or your prior employer...the one who just fired you?

Moving Money from the 401k to a Traditional IRA

It is a simple process to move those monies, tax free is an added benefit, from your old employer's 401k(or similar plan) to your personal retirement account. The simplest way is to transfer those funds, is to transfer them to a traditional IRA. This account functions, with regards to taxation purposes, just like the 401k type plans--making the transfer is quite simple, and it is easy to complete. Since the IRA is only the qualified tax plan, however, there are a variety of financial services tools that can be used inside the IRA to build monies for retirement.

Moving Money from the 401k to a Roth IRA(Or similar Plan)

Suppose you want to transfer the monies to a Roth IRA? Or, you are seeking to be more creative, and you wish to transfer the monies to another sort of retirement vehicle? This will trigger a taxable event, as the Roth IRA does not function like a Traditional IRA, or a 401k plan. With a Roth IRA, taxes are paid on the monies prior to the contribution to the IRA, yet at the time of the withdrawal of those monies, at retirement, the funds are not taxed. 401k type plans work in the inverse: The contribution into the plan receives a tax benefit, but the withdrawal monies, at retirement, are taxed as earned income.  This can be done, just realize there is a taxable consequence to consider. Just like the traditional IRA, there exists many different financial services tools to use inside the Roth IRA to help accumulate wealth for retirement.


Conclusion

Losing a job can be a downer. However, do not leave your retirement monies with your old employer's 401k plan. It is a painless process to move those monies out of that plan, into a plan that you control. Move those monies, and then focus on getting another job. When you decide to move your monies, always develop a financial plan to follow to ensure that you meet your financial goals.

Sunday, February 14, 2016

The Federal Reserve and Other Retirement Risks

The Federal Reserve’s growing balance sheet is a major concern for professional investors. However, it should be a growing concern for main stream investors, and it should be a concern for folks looking at retirement in the near future. Why should this be a concern for individuals attempting to accumulate wealth for retirement, and seeking to use their retirement funds to enjoy the golden years? What other concerns should individuals have while planning for retirement?

Background

The Federal Reserve’s balance sheet has grown since the Great Recession of 2008. The Federal Reserve began purchasing US Government Debt instruments via programs such as Operation Twist. When the Fed purchases Government debt (Bonds), it does not purchase them directly; it purchases them via a 3rd party dealer. This purchase, in turn, increases the money supply.  The Fed creates the cash, from a computer entry, and the purchase occurs. Due to the rules of the fractional banking system, the money supply is increased once that purchase check is deposited.

Here is an example a chart here showing the growth of the Federal Reserve’s balance sheet:












Eventually, the Federal Reserve must have an exit strategy to deal with this debt from the growing balance sheet. What is the strategy? Raising interest rates? Selling off the debt? What is it?


Inflation Concerns

Recall, for readers who frequent this blog, the definition of inflation: It is the increase of the monetary stock or base.  The monetary base is increased, as the Fed continues to purchase more US Government Debt.  Inflation impacts individuals that are on fixed incomes, which are typically retirees.  As the monetary base is debased, the ability for retirees to spend dollars on goods and services alters dramatically.  This means that retirees must have the ability to have their investment dollars outpace inflation.

Analysts love to cite the CPI as a measure of inflation; however, this is not an accurate measure of inflation. Looking at various factors, such as commodity prices, is one way of looking at inflation. Food prices should be analyzed as well, with regards to looking at inflation. While food prices, as well as commodity prices have dropped considerably since 2008, they are still higher than they were 10 years ago.

Graph of Food Prices:





Graph of Commodity Prices:







Individual Savings Rate

Currently, the individual savings rate is around 5.5%, as of December 2015. Since the 1950s, the individual savings rate has shown a downward trend. This is an interesting trend.  From an economics perspective, savings is needed to expand the economy and spur economic growth.  If the savings rate is down, this could be a harbinger for things to come.  As a retiree, one must review their stocks accordingly. Should my equities include companies that are seeking to expand? Can they expand if there is a declining savings rate? If this is the trend, how should one manage their portfolio?

A graphical display showing the trend of the individual savings rate:











Taxes 

Currently, the marginal income tax rates are the lowest in decades. With the United States Government debt load reaching its zenith, and the demand of the use of Social security, Medicare, Obamacare, and the like, politicians will seek to raise tax rates.  In fact, some of the leading presidential candidates are proposing to raise taxes on the “rich”. For example, Donald Trump says the following:
“If you look at actually raise, some very wealthy are going to be raised. Some people that are getting unfair deductions are going to be raised. But overall it’s going to be a tremendous incentive to grow the economy and we’re going to take in the same or more money. And I think we’re going to have something that’s going to be spectacular.” (Nolte, 2015)
Presidential Candidate Bernie Sanders is pushing the following:

“Mr. Sanders has proposed a headline top tax rate of 52 percent, applying only to incomes over $10 million. But that’s just the federal income tax. When you combine it with other taxes that apply to income, like existing payroll taxes and new ones Mr. Sanders would impose to pay for Social Security, single-payer health care and family leave, and then add those on top of taxes levied by state governments, it would add up to a combined tax rate of over 73 percent on the highest incomes, more than 20 points higher than today. That’s in the average state — maximum rates in high-tax jurisdictions like California and New York City would be even higher.” (Barro, 2016)

One should consider that all sorts of tax increases could occur; this is to include an increase with Estate Taxes.  No one knows for sure if this will happen, however, there needs to be a plan in place to deal with this tax risk.

Conclusion

Saving retirement in this economic climate will be a challenge. All of these aforementioned items must be considered while designing a plan for retirement. These risks are real concerns, and building an solution to protect and grow your hard earned cash should be the objective. This can be done, as there are solutions to mitigate these risks. If you are at retirement age, these things, and many other items, should concern you. Attempting to mitigate your tax liability, while at retirement, should be one of the top priorities in dealing with your economic plan. Ideally, having a Tax Free retirement should be the objective.



Works Cited

Barro, J. (2016, Febuary 9). Bernie Sanders' Plan Would Test an Economic Hypothesis. New York Times.
Nolte, J. (2015, September 28). Trump Pushes Single Payer Healthcare, Tax Increases on the Wealthy. Breitbart.



Tuesday, February 9, 2016

Questions Regarding Inflation

Many folks have concerns about inflation and deflation. Addressed below are questions submitted by the vox populi regarding this topic. Before addressing the questions, the definition of inflation and deflation must be addressed.


Definition of Inflation

Inflation is the increase of the monetary base. If the central bank decides to increase the money supply, this is inflation.

Who is negatively impacted greatly by inflation?

When inflation occurs, it increases the monetary base. Once the monetary base has increased, it makes the next monetary base unit less "valuable", on the margin. The net result is that the currency because weaker, it it loses its ability to store value for consumers. Individuals who are are on a fixed income, such as retirees, savers, and the like are impacted greatly by inflation. Individuals who are creditors are impacted by inflation as well. Why is this the case? When someone creates a debt, it is based on today's dollars, but the interest rate helps adjust the total amount paid to future dollars. If inflation occurs, the interest rate on the debt is fixed, it does not adjust to the increase in the money supply. So, those future dollars maybe less valuable if there is inflation, and the interest rate on the debt does not account for this.

How Savers are impacted by Inflation

The act of savings is deferred consumption for the future. For example, one may save up to purchase a house in the future, utilizing the savings as a down payment. The saver is placing faith that the monetary base, in most cases the currency, holds the value during the time the person is saving up to purchase the item. When inflation occurs, the value is eroded,

How to protect yourself from Inflation

There are various strategies to mitigate against the risk of inflation. Some advisers suggest purchasing Gold, Silver or other commodities to hedge against inflation. Many also invest into equities, as this can be a way to deal with inflation. Others may look into Real Estate investing, as this is a popular method to deal with an increasing currency supply. While all of these methods, and many others, are appealing, they have their own risks. The main takeaway is to make sure one is educated on how to invest into these various investment classes.







Wednesday, January 20, 2016

Chinese Currency Manipulation and Price Controls

The curious claim made against the Chinese about "Currency Manipulation" is gaining momentum. Many believe that the United States are "losers" in trade relations with China.  Somehow these modern day mercantilists believe that this impacts the trade deficit with China. In reality, the United States benefits from China's "currency manipulation", at the expense of the Chinese citizens. To have a deeper understanding why this is true, "currency" must be analyzed as a good, and the Chinese government, in effect, is placing price controls on its currency. When analyzed under this light, the outcome is pretty clear: the Tax Payer class in China pays the economic cost of this action.

Economic Theoretical Considerations of Price Controls

In economics, there are two types of price controls. The first type is where the Government places a price maximum on a particular good or service. When this happens, the price maximum is above the equilibrium price. Based on the law of demand, the stock of the goods will increase, thus creating a surplus of that particular good. An example of this is the "ghost" cities in China. There are many buildings that are empty because the prices of those buildings are above the equilibrium price. The second type of price control is where the Government places a price minimum on a particular good. In the event of having the Government implements a price control that is below the equilibrium price, a shortage occurs. An example of this situation is the long gas lines that occurred during the 1970s when the Government implemented price controls.

Currency Manipulation is a form of Price Control

To move forward in this analysis, one must look the currency as a "good". Looking back at the claim that China is manipulating its currency, let us look at the ways that this falls under the two forms of price controls, as mentioned previously. When the Central Bank decides to increase the money supply, based on the Central Bank's estimates, and not what the market demands, it is placing a price maximum on the currency. This creates a surplus of currency in circulation. On the other hand, if the Central Bank decides to remove currency out of the circulation, but not based on what the market demands, it is creating a price minimum on the currency.

The Case with China 

The Chinese currency, relative to the US dollar, in this exchange, is a victim of price controls. There is an exchange ratio between the US Dollar and the Chinese Yuan. That ratio is "fixed"(sort of). When the Chinese central bank increases the Yuan supply, it creates a surplus of Yuan in circulation. Since there is an increase of Yuan in circulation, this devalues the Yuan, in terms of the US Dollar. Since the US Dollar is not commonly used by the vast majority of the Chinese citizens, and those citizens use Yuan to purchase goods and services, the Chinese citizens pay the price for the increase in the money supply. This is inflation. The Chinese citizens will see the prices, as expressed in Yuan, increase. This also usurps their savings, and it impacts citizens that are on fixed incomes. The goods they normally purchase take more Yuan to purchase, yet the dollar becomes stronger, relative to the Yuan.

Who Benefits from Chinese Currency Manipulation? 

It is obvious that the Chinese citizens are not benefiting from currency price fixing. The savers lose out, and the folks on fixed income also lose too. But, the folks who can hold US Dollars are "winners" in this scenario. Why is this true? Since the Yuan is being held to a price maximum, and a surplus is created, this drives down the value of the currency. Yet, assuming the US Dollar stays constant, this raises the value of the Dollar, relative to the Yuan.  The holders of the US Dollar, who live in China, they all benefit greater than the other residents who use Yuan.

Conclusion

This dynamic is simply an expression of Gresham's Law. The higher valued currency, drives out the lower valued currency, albeit in a "black market".  In this case, the US Dollar and Gold are held by a minority of individuals, political class and the tax consumer class--and the Chinese Tax Payer is using the devalued Yuan to use to purchase goods and services. This entire scheme is all set up by the Chinese central bank and Chinese government.